Vodafone verdict may encourage round tripping and treaty shopping.

The Vodafone case was a global test for India’s legal and tax system. Perhaps, in one of the most important verdicts in Indian corporate history, the Supreme Court has made it clear that the tax department has no right to levy tax on share sale carried out by two overseas entities, even if the underlying assets are in India. The verdict has cancelled the tax departments claim of around Rs 11500 crore tax on the deal.

Despite the revenue loss for the national exchequer, positives are extracted by analysts out of the verdict. The verdict has given clarity on taxation issues related to foreign investment. This in turn is the biggest positive externality of the verdict. In the future, foreign investors may consider India as a sound destination with certain tax and legal set up.

At the same time, a major issue of policy implication is that the verdict will encourage treaty shopping and round tripping. Investors, both domestic and foreign, were observing how the Indian tax and legal system are approaching new generation globalization activities like treaty shopping and round tripping. Treaty shopping is a practice featuring residents of a third country (Vodafone and Hutchison) taking advantage of a beneficial tax treaty between two countries (India and the Camay Islands) to lower their tax liability. Round tripping refers to the practice where, capital belonging to a country (India), which leaves the country (and invested in Mauritius) and then is reinvested in the form of FDI (back to India). Large number of Indian corporate are taking money out of India to invest in the Mauritius after registering a shell company there. This invested fund is taken back to India. The profit out of such investment can’t be taxed in India as the fund is coming from Mauritius. In Mauritius, this income is not taxed or taxed at an insignificant rate.

These two practices are instances by corporate of utilizing tax havens to escape from taxation. Companies are adopting treaty shopping and round tripping practices as part of their tax planning. Perhaps the most significant aspect of the Supreme Court verdict is that it has given a legal validity to treaty shopping and round tripping. Vodafone is registered in the Netherlands, whereas, CGH, the holding company which held Hutchison’s share is incorporated in another tax haven of Camay Islands. The standard practice on taxation of global income is that companies have to pay taxes on their residence or country where they are registered. They need not pay tax in their country of incorporation as there is nil or little taxation in Camay Islands as well as in the Netherlands.

In future, Indian corporate also may form shell companies such as CGH to reduce their tax liabilities on merger and acquisitions.